Techniques and Tools of Risk Management Unit III-DBM,OU (Forwards & Futures)

Introduction
The emergence of the market for derivative products can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. Thus, derivative products initially emerged as hedging devices against fluctuations in commodity prices. Commodity linked derivatives remained the sole form of such products for almost three hundred years.

Derivatives
Derivative is a product whose value is derived from the value of the underlying asset. Underlying asset can be Equity, Forex (Currency), Commodity, or any other asset. According to the Securities Contracts (Regulation) Act, 1956, derivatives are those assets whose value is determined from the value of some underlying assets. The underlying asset may be equity, commodity or currency. A common place where such transactions take place is called the derivative market.

Derivatives
Financial products commonly traded in the derivatives market are themselves not primary loans or securities. But can be used to change the risk characteristics of underlying asset or liability position, they are referred to as 'derivative financial instruments' or simply 'derivatives.' These financial instruments are so called because they derive their value from some underlying instrument and have no intrinsic value of their own. The world over, derivatives are a key part of the financial system.

Range of derivative Products Derivatives

Forwards/ Options Futures

Swaps

Features of Derivative markets Centralization of Trading No counter party risk Standardization of contracts Liquidity Mark to Market (MTM) margining system

Standardisation of Contracts
The standardised items in any futures contract are: i. Quantity of the underlying asset ii. Quality of the underlying asset(not required in financial futures) iii. The date and month of delivery iv. The units of price quotation (not the price itself) and minimum change in price (tick-size) v. Location of settlement

Derivatives - Demystified
Four Variants: Forward: Contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price. The forward price may be different different maturities. for contracts of

 Futures Contract:

Derivatives - Demystified

Is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. > 99% of futures transactions are offset this way.

Derivatives - Demystified
 Options: Contract gives the right, but not the obligation to buy or sell a specified quantity of the underlying at a fixed exercise price on or before the expiration date. A call option gives the right to buy and a put option gives the right to sell.  Swaps: Are private agreements between two parties to exchange cash flows in the future according to a pre-arranged formula. The two commonly used swaps are interest rate swaps and currency swaps.

Forward Contracts
An agreement made today between a buyer and a seller to exchange the commodity or instrument for cash at a predetermined future date at a price agreed upon today. The agreed upon price is called the forward price. Two parties agree to do a trade at some future date, at a stated price and quantity. No money changes hands at the time the deal is made. OTC Quantities and terms of the contract are fully negotiable. Secondary market does not exist and faces problems of liquidity and negotiability.

Features
Custom Tailored Traded over the counter (not on exchanges) No money changes hands until maturity High counter party risk

 A wheat farmer may wish to contract to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such transaction would take place through a forward market.

Features of Futures Contracts

1. Standardised contracts:
(a) underlying commodity or asset (b) quantity (c) maturity

2. Exchange traded 3. Guaranteed by the clearing house no counter-party risk 4. Gains or losses settled daily 5. Margin account required as collateral to cover losses

Futures Contracts
Traded on a futures exchange as a standardised contract, subject to the rules and regulations of the exchange. It is standardisation of the futures contract that facilitates the secondary market trading. Relates to a given quantity of the underlying asset and only whole contracts can be traded. Terms not negotiable A futures contract is a financial security issued by an organised exchange to buy or sell a commodity, security or currency at a predetermined future date at a price agreed upon today. Price is called Futures Price

Example
Suppose an investor contacts his broker on July,2010 to buy two December 2010 gold futures contracts on the XYZ Commodity Exchange. We suppose that the current futures price is $1250 per ounce. Since the contract size is 100 ounces, the investor has contracted to buy a total of 200 ounces at this price. The initial margin is $5000 per contract or $10,000 total. A maintenance margin of $3500 or $7000 is set.

Day

Future s Price$

Daily Gain/L oss $

Cumul ative Gain(L oss) -1000 -200 -1400 -1000 -1800 -2800 -2000 -2600 3600 -4000

Margin Accou nt Balanc e$ 9000 9800 8600 9000 8200 7200 8000 7400 6400 13400

Margin Call

July 9 July 10 July 11 July 12 July 13 July 14 July 15 July 16 July 17 July 30

1245 1249 1243 1245 1241 1236 1240 1237 1332 1232

-1000 800 -1200 400 -800 -1000 800 -600 -1000 -600

3600

 We can infer that: Standardisation makes futures liquid Margin and marking to market reduce default risk Clearing-house guarantee reduces counter-party risk

Types of Futures
Types of Futures Futures contracts can be classified into four categories. They are:
Interest Rate Futures Index Futures Currency Futures Commodity Futures

Interest Rate Futures

Interest rate futures are based on an underlying security which is a debt obligation. An interest rate future moves in value according to the changes in the interest rates. In a market condition in which the interest rates are moving higher, the futures contract buyer has to pay the seller an amount equal to that of the profit accrued by investing at a higher rate in comparison to that of the rate specified in the futures contract. On the contrary, when interest rates move lower, the futures contract seller compensates the buyer for the lower interest rate at the time of expiration.

 An interest rate futures price index was created in order to accurately determine the gain or loss of an interest rate futures contract. This price index fluctuates in accordance with the interest rates. In other words, when the interest rates increase, the index will move lower and vice versa. Examples include Treasury-bill futures, Treasury-bond futures and Eurodollar futures. By now, it is quite clear that the interest rate futures are used to hedge against the risk of the interest rates that will move in an adverse direction, causing a cost to the company.

Index Futures
Index or Stock index futures are one of the varieties of futures contracts. The first stock index futures contract based on value line index were introduced by Kansas City Board of Trade (KCBT) on 24th February, 1982. Two months later, the Standard and Poor (S&P) 500 Index futures contract was introduced by the Chicago Mercantile Exchange (CME). Others 1. India BSE SENSEX, NSE, CNX, NIFTY 2. US DJIA, S&P 500, NYSE, RUSSELL 2000, NASDAQ 100 3. Japan NIKKEI 4. Germany DAX 5. UK PTSE 100 6. France

 Trading in Sensex or Nifty futures is just like trading in any other security. An investor is able to buy or sell futures on the BSE Bolt terminal or the NSE NEAT screen with his broker. In the trading, the order will have to be punched in the system. The confirmation from the system will be immediate like the existing system. Since the tick size and market lot size in futures are similar to individual stock, the feel of trading in stock index futures is the same as trading on stocks. Separate bids and ask quotations are available like shares.

 Simply, the investor has to punch in the order of the required quantity at a price he wishes to buy, sell or execute the same at the market price. Upon execution of the order he would receive a confirmation of the same. A trader can carry the stock index futures contract till maturity or square it off at any time before expiry.

Currency Futures
Currency future, is a futures contract to exchange one currency for another at a specified future date at a price (exchange rate) fixed on the purchase date. More popularly, currency future is called as foreign exchange future or FX future. Usually, one of the currencies of exchange in such contracts is US dollar. The price of the futures contract of this type is hence measured in terms of US dollars per unit of other currency. The trading unit of each contract is a particular amount of the other currency, for example, Rs. 290,000. Most of the currency futures contracts have a physical delivery, so as to make the actual payments of each currency for those held at the end of the last trading day.

 Currency futures contracts are similar to the currency markets, but there are certain significant differences between them. One such difference is that the currency futures are traded through exchanges, such as the Chicago Mercantile Exchange (CME), but the currency markets are traded through currency brokers. Thus, the currency markets are not as controlled as the currency futures.

Popular Currency Futures Markets

Name Description EUR The Euro to US Dollar currency future GBP The British Pound to US Dollar currency future CHF The Swiss Franc to US Dollar currency future AUD The Australian Dollar to US Dollar currency future CAD The Canadian Dollar to US Dollar currency future RP The Euro to British Pound currency future RF The Euro to Swiss Franc currency future

Commodity Futures
Commodity futures can be defined as those futures where the underlying is a commodity or physical asset. The underlying commodity can be wheat, cotton, butter, eggs and so on. Such contracts began trading on Chicago Board of Trade (CBOT) in 1860s. In India too, futures on soya bean, black pepper and spices have been trading for long.

Future Price Quotations

Cost of Carry Model Expectancy Model

 If Futures price is greater than the Fair price, it is better to buy in the cash market and simultaneously sell in the futures market. If Futures price is less than the Fair price, then it is better to sell in the cash market and simultaneously buy in the futures market. This arbitrage between cash and future markets will remain till prices in the cash and future markets get aligned.

Expectancy Model of Futures Pricing

Expectancy model says that many-atime it is not the relationship between the fair price and future price but the expected spot price and future price which leads the market. This happens mainly when underlying asset or instrument is not storable or may not be sold short, for instance, in the commodities market.

Hedging, Speculating & Arbitrage:

Hedging is a mechanism to reduce price risk inherent in open positions. Derivatives are widely used for hedging. A Hedge can help lock in existing profits. Its purpose is to reduce the volatility of a portfolio, by reducing the risk.

Hedging, Speculating & Arbitrage:

Speculation involves taking a view on the market and playing accordingly. If one is bullish on the market, one can buy Futures, and vice versa for a bearish outlook.

Arbitraging involves profiting from the price discrepancy between two markets. For example: Cash Market and the Futures Market. Arbitrageur helps price discovery.

Hedgers, Speculators and Arbitrageurs:

Hedgers:
Hedgers wish to eliminate or reduce the price risk to which they are already exposed. Hedgers and investors provide the economic substance to any financial market. Without them the markets would lose their purpose and become mere tools of gambling.

Speculators:
Speculators are those class of investors who willingly take price risks to profit from price changes in the underlying. Speculators provide liquidity and depth to the market.

Hedgers, Speculators and Arbitrageurs:

Arbitrageurs:
Arbitrageurs profit from price differential existing in two markets by simultaneously operating in two different markets. Arbitrageurs bring price uniformity and help price discovery. The market provides a mechanism by which diverse and scattered opinions are reflected in one single price of the underlying.

All class of investors are required for a healthy functioning of the market.

Terminology
The party that has agreed to buy has what is termed a long position

The party that has agreed to sell has what is termed a short position

36

Distinction -Forwards and Futures Market

Difference
Size of Contract Price of contract Mark to market Margin Counterparty Risk No. of contracts in a yr. Hedging Liquidity Nature of Market Mode of Delivery

Forwards
Decided by Buyer and Seller Remains fixed till maturity Not done No margin required Present Any no. of contracts Perfect hedging is possible. No Liquidity Over the counter Specifically decided.Most contracts result in delivery.

Futures
Standardized in each contract Changes everyday Market to market everyday Margin paid by buyers and sellers Not present Restricted no. contracts per year Perfect hedging is not possible. Highly Liquid Exchange traded Standardized. Most of the contracts are cash settled.

Margins In Futures Market

A margin is cash or marketable securities deposited by an investor with his or her broker(collateral). A margin is not a form of down payment on the balance due. Margin payments are made frequently (usually daily) in small amounts relative to the size of the contract rather than as a big sum. The balance in the margin account is adjusted to reflect daily settlement (marking to market) Margins minimize the possibility of a loss through a default on a contract
38

Margins In Futures Market

Other Key Points About Futures

They are settled daily Closing out a futures position involves entering into an offsetting trade Most contracts are closed out before maturity

40

Futures/Forwards: Equity Markets

Derivatives Products in Indian Equity Markets

Futures on indices Futures on Single Stocks Options on indices Options on Single Stocks

Theoretical Pricing of Futures

Futures Price = Spot Price + Cost of Carry Basis = Futures Price Spot Price (Positive/Negative) Insurance/Storage/Interest/Less Dividend Cost of Carry reduces as time to expiry reduces and futures & cash price start converging On expiry day, futures and cash price should be equal. Actual futures & spot price would depend on demand and supply of underlying and futures

Futures Pricing: Equity Markets

In the case of commodity futures, the holding cost is the cost of financing plus cost of storage and insurance purchased.

In the case of equity futures, the holding cost is the cost of financing minus the dividends returns.

Futures Pricing: Equity Markets

Futures Discrete compounding of Interest rates) Pricing: An example (Using

Futures Pricing: Equity Markets

The concept of discrete compounding, where interest rates are compounded at discrete intervals, for example, annually or semiannually. Pricing of options and other complex derivative securities requires the use of continuously compounded interest rates. Most books on derivatives use continuous compounding for pricing futures too. When we use continuous compounding,

Futures Pricing: Equity Markets-stocks

Using Continuous compounding of interest rate-

S spot price of a equity share

Futures Pricing: An example

(Using Continuous compounding of interest rates )

Futures Pricing: Equity Markets- When dividends are paid on a stock

When an Investment Asset Provides a Known Income

F = (S I )erT
where I is the present value of the income during life of forward contract
S: Spot price today F: Futures or forward price today T: Time until delivery date r: Risk-free interest rate for maturity T

54

Futures Pricing: Equity Markets- When dividends are paid on a stock

An Example : When an Investment Asset Provides a Known Income

ABC ltd., is trading at Rs.900. calculate its 1 year futures price if dividend paid is Rs. 40 at the end of half year and year. If the risk free rate with continuous compounding is 10% per annum. Sol: S= Rs.900; T=1; r=10%
I = 40e -0.10*0.5 + 40e -0.10*1 F = (S I )erT = 38.049 + 36.193 = 74.24

F = (900 74.24) e0.1*1 = 912.60

Futures Pricing: Equity Markets- When dividends are paid on a stock

When an Investment Asset Provides a Known Yield

F = Se (rq )T
where q is the average yield during the life of the contract (expressed with continuous compounding) S: Spot price today F: Futures or forward price today T: Time until delivery date r: Risk-free interest rate for maturity T

Futures Pricing: Equity Markets- When dividends are paid on a stock

An Example: When an Investment Asset Provides a Known Yield

ABC Ltd., is currently trading at Rs. 25 , the yield/return is 8% per annum. The risk-free rate with continuous compounding is 12%,Calculate the 1 year future price of ABC ltd. Sol: S=25; T= 1; r = 12%

F = Se (rq )T
F = 25 e (0.12-0.08) * 1 = Rs. 26.02

Futures Pricing: Equity Markets- Stock Index

Can be viewed as an investment asset paying a dividend yield The futures price and spot price relationship is therefore

F = S e(rq )T
Where q is the average dividend yield on the portfolio represented by the index during life of contract

58

Long & Short Hedges

A long futures hedge is appropriate when you know you will purchase an asset in the future and want to lock in the price

A short futures hedge is appropriate when you know you will sell an asset in the future and want to lock in the price

59

Equity Markets: Index Futures- NIFTY(NSE)

Other index futures on NSE are: CNX IT , Bank Nifty, CNX Nifty Junior, Nifty Midcap 50

Equity Markets: Stock Futures-(NSE)

Stocks available for futures trading: Infosys,Wipro,HUL,SBI,ITC,HPCL,NTPC etc.,

Some Terminology
Open interest: The total number of contracts outstanding equal to number of long positions or number of short positions Settlement price: The price just before the final bell each day used for the daily settlement process Volume of trading: The number of trades in 1 day

62

Basis & Convergence in Futures

Basis: The difference between the spot price and the futures price is called the basis. We see that as a futures contract nears expiration, the basis reduces to zero. This means that there is a convergence of the futures price to the price of the underlying asset. This happens because if the futures price is above the spot price during the delivery period it gives rise to a clear arbitrage.

Basis & Convergence in Futures

Basis Risk:
Basis is the difference between the spot and futures price. In a normal market basis is ve The variability of the basis is called basis risk Hedge eliminates the outright price risk and substitutes it for less volatile and more manageable basis risk. Basis risk arises because of the uncertainty about the basis when the hedge is closed out The effectiveness of any hedge strategy depends upon the stability of the basis
64

Convergence of Futures to Spot:

Basis & Convergence in Futures

Futures Price Spot Price Futures Price

Spot Price

Time

Time

(a)

(b)

65

Convergence of Futures to Spot

(Hedge initiated at time t1 and closed out at time t2)

Futures Price

Spot Price
Time t1 t2
66

Futures/Forwards: Commodity Markets

Commodities Defined
Commodity Derivatives : Derivative contracts where
the underlying assets are Commodities are called Commodity derivatives Every kind of movable good excluding monies, securities and actionable claims The commodity markets can be classified into:
Agricultural Products Precious Metals Other Metals Energy

Ticker Format
Ticker : AAABBBCCC AAA : Commodity BBB : Grade CCC : Location For Example : GLDPURMUM GLD : GOLD PUR : PURE MUM : MUMBAI

Instrument Type
Instrument type denotes the type of contract COMDTY : Commodity (Spot) FUTCOM : Future Commodity OPTCOM : Option on Commodities Only trading in Futures is Allowed by FMC

Expiry Date
Contract Expiry is on 20th of Every month If 20 is a holiday, the previous working day would be the Expiry date Ticker: 20MMMYYYY For Example : Gold contract for the month of August 2004 would be : 20AUG2004 Expiring Contracts can only be traded up to the morning session on the closing date.

Lot Size
Specific lot size for every commodity

For Example : For Gold Contracts Prices Displayed : Per 10 Grams Minimum Contract : Per 100 Grams (& in multiple thereof) Delivery Lot : Per 1 Kilo

Commodity Futures
The buyer of the futures contract (the party with a long position) agrees on a fixed purchase price to buy the underlying commodity (gold, silver, castor seed, refined soy oil or rubber) from the seller at the expiration of the contract. The seller of the futures contract (the party with a short position) agrees to sell the underlying commodity to the buyer at expiration at the fixed sales price. As time passes, the contract's price changes relative to the fixed price at which the trade was initiated. This creates profits or losses for the trader.

Payoff for buyer of futures: Long futures

Payoff for buyer of futures: Long futures

Payoff for Seller of futures: Short futures

Payoff for a seller of gold:

Profit

6000 Loss

Payoff for buyer of futures: Long futures

Payoff for buyer of cotton futures:
Profit

6500

Loss

Payoff for Seller of futures: Short futures

Payoff for Seller of futures: Short futures

iiiiii Short staple cotton

Short

Futures Pricing: Commodity Mkts.

The theoretical price of a futures contract is the spot price of the underlying commodity plus the cost of carry. Please note that futures are not about predicting the future prices of the underlying asset or commodity. In general, Futures Price = Spot Price + Cost of Carry. The cost of carry is the sum of all costs incurred if a similar position is taken in the cash market and carried to expiry of the futures contract less any revenue that may arise out of holding the asset. The cost typically includes interest cost in case of financial futures; in case of commodity futures, insurance and storage costs etc are also considered.

Though one can compute the theoretical price, the actual price may vary depending upon the demand and supply of the underlying asset or commodity

Futures Pricing: Commodity Mkts.

The futures price of a commodity that is an investment asset is given by Storage costs add to the cost of carry. If U is the present value of all the storage costs that will be incurred during the life of a futures contract, it follows that the futures price will be equal to

Futures Pricing: Commodity Mkts.

For ease of understanding let us consider a one.year futures contract on gold. Suppose the fixed charge is Rs.310 per deposit upto 500 kgs. and the variable storage costs are Rs.55 per week, it costs Rs.3170 to store one kg of gold for a year(52 weeks). Assume that the payment is made at the beginning of the year. Assume further that the spot gold price is Rs.6000 per 10 grams and the risk. free rate is 7% per annum. What would the price of one year gold futures be if the delivery unit is one kg?
3 month gold futures price for above example:

Futures Pricing: Commodity Mkts.

Futures/Forwards: Currency Markets

Currency Forwards
The simplest derivative It is buying or selling of a currency against another at a fixed price at a future date.

Currency Futures
Hedging with Currency Futures A corporation has an asset e.g. a receivable in a currency A. To hedge it should take a futures position such that futures generate a positive cash flow whenever the asset declines in value. The firm is long in the underlying asset, it should go short in futures i.e. it should sell futures contracts on A against its home currency. When the firm is short in the undelying asset a payable in currency A it should go long in futures. Cash Position: Receive A; Futures Position: Deliver A Cash Position: Deliver A; Futures Position: Receive A

Forwards Risk Reward

FORWARD PAY OFF
1.5

Seller
1 0.5
G IN SS A /LO

-0.5

-1

-1.5

Buyer
45 .4 45 .6 46 .2 46 46 .4 47 .2
PRICE

Buyer Seller

Price

47 .6

46 .8

47 .4

45

45 .2

45 .8

46 .6

47

Futures Pricing: Currencies

F = S e( rd-rf ) T
F = Futures or forward price S = current spot price rf = foreign risk-free interest rate rd = Domestic risk-free interest rate T =Time until delivery date

Futures Pricing: Currencies

Calculate 1 yr futures price, spot Rs/$ : Rs45/$ , 1yr interest rates in india and U.S being 12% and 7%. Sol: F

= S e( rd-rf ) T

S = Rs.45/$ ; rd =12% ; rf = 7%; T = 1 F = 45 e (0.12-0.07)

1

= Rs.47.307 / $

Hedging Strategies Using Futures

Hedge Ratio
The ratio of the size of a position in a hedging instrument (like futures) to the size of the position (exposure) being hedged. In situations where the underlying asset in which the hedger has an exposure is exactly the same as the asset underlying the futures contract he uses, and the spot and futures market are perfectly correlated, a hedge ratio of one could be assumed. In all other cases, a hedge ratio of one may not be optimal.

Optimal Hedge Ratio

Proportion of the exposure that should optimally be hedged is
h*=

where WS is the standard deviation of (S, the change in the spot price during the hedging period, WF is the standard deviation of (F, the change in the futures price during the hedging period V is the coefficient of correlation between (S and (F. h * is the hedge ratio that minimizes the variance of the hedgers position
92

WS V WF

Optimal Hedge Ratio

Optimal number of contracts: The no. of futures contracts required for hedging: N* = h* N A / Q F N* = optimal no. of futures contracts for hedging Q F = Size of one futures contract (units) N A = Size of position being hedged

An Example on Hedge ratio

A company knows that it will require 11,000 bales of cotton in three months. Suppose the standard deviation of the change in the price per Quintal of cotton over a three month period is calculated as 0.032. The company chooses to hedge by buying futures contracts on cotton. The standard deviation of the change in the cotton futures price over a three month period is 0.040 and the coefficient of correlation between the change in price of cotton and the change in the cotton futures price is 0.8. The unit of trading is 11 bales and the delivery unit for cotton on the NCDEX is 55 bales. What is the optimal hedge ratio? How many cotton futures contracts should it buy?

An Example on Hedge ratio

Solution: If the hedge ratio were one, that is if the cotton spot and futures were perfectly correlated, the hedger would have to buy 1000 units (one unit of trading = 11 bales of cotton) to obtain a hedge for the 11,000 bales of cotton it requires in three months. Number of contracts = 11,000/11 N* = 1000 But the optimal hedge ratio is: h*

= 0.8 * 0.032/0.040 = 0.64

No. of Contracts = 0.64* 11000/11 = 640; N* = 640

An Example on Hedge ratio

A company knows that it will require 33,000 bales of cotton in three months. The hedge ratio works out to be 0.85. The unit of trading is 11 bales and the delivery unit for cotton on the NCDEX is 55 bales. The company can obtain a hedge by

An Example on Hedge ratio

Solution:
The company obtains a hedge by: The optimal no. of contracts is given by,

N* = h* N A / Q F

N* = 0.85 * 33000/11 = 2550

Thus the company obtains hedge by buying 2550 units of 3-months cotton futures.

Why Hedge Equity Returns

To hedge an equity portfolio

May want to be out of the market for a while. Hedging avoids the costs of selling and repurchasing the portfolio

Suppose stocks in your portfolio have an average beta of 1.0, but you feel they have been chosen well and will outperform the market in both good and bad times. Hedging ensures that the return you earn is the risk-free return plus the excess return of your portfolio over the market.

98

Hedging Using Index Futures : To hedge an equity portfolio

To hedge the risk in a portfolio the number of contracts that should be shorted is
P N* = F F where P is the value of the portfolio, Fis its beta, and F is the value of one futures contract N* = optimal no. of futures contracts for hedging
99